This blog aims to study the mechanics of business and occasionally find a gem of insight.

(Consult your financial adviser before making investment decisions. Following the advice here does not guarantee performance and there is a substantial risk of loss)

Friday, March 13, 2009

Market Net Neutral Positions

The most common long / short strategy is the 130/30 (or the 1x0 / x0). Where there is a small cash position in a stock (100%) and an accelerated growth component in the form of a small shorting position (30%). The cash taken from the short position is used to take a leveraged long position. The idea is that the long position should out perform the short, netting a profit equal to the difference in performance (Gain in Equity A minus Gain in Equity B) multiplied by the weight of the short position (x0%). Notice that this relationship holds even if both stocks are declining (but B declines faster than A). Obvious problems appear if B outperforms A in which case the leverage works against you.

A market net neutral position is one that employs a long / short strategy such that the investor has no cash position in the market. That is to say that the cash obtained from the short position is used to support the long position (100 / 100).

In the same way, profit is made when the price of the long position grows at a rate faster than that of the short position. If the short position loses money, your profit margins are amplified. The same obvious risks apply: a bad bet and that the short position will grow faster than the long position.

Other variations include the idea of market growth leaders: Being long in a market growth leader's stock and being short on the market index. This bet is essentially saying that you think this company will grow, but you want to hedge against a general decline in the market sector.